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Ruling

Subject: Income-lump sum payment

Question 1

Is the lump sum payment you have received from an insurer in relation to your income protection insurance policy, assessable as ordinary income?

Answer: No

Question 2

Is the lump sum payment that you have received from an insurer in relation to your income protection insurance policy, included in assessable income under the capital gains tax (CGT) provisions?

Answer: No

Question 3

Is a deduction allowable for the legal expenses that you have incurred in relation to the proceedings against the insurer?

Answer: No

This ruling applies for the following period:

Year ended 30 June 2011

The scheme commenced on:

1 July 2010

Relevant facts

You have income protection insurance policy.

You were employed as a consultant.

You suffered an illness.

You made a claim on your income protection policy.

Your claim was for total disability from a certain date and into the future.

Your insurer denied they were required to make payments from that date as you only met the policy requirement of being under the regular care of a doctor from a later date.

You took legal action against the insurer for the breaching the policy and to recover the following:

· income protection benefit

· for the premiums paid

· damages

· interest pursuant to the Insurance Contracts Acts 1994 (Cth)

· loss of use of the said sum

· compensation for the taxation consequences of receipt of the periodic payments as a lump sum.

As a result of the legal proceedings you and the insurer reached an agreement whereby the insurer agreed to pay a lump sum settlement amount to forever release and discharge them from all present or future causes of action, claims or demands a rising out of the policy for a certain period.

The settlement amount was a one off payment.

You received a lump sum payment and no tax was withheld from the payment.

The insurer did not provide a break-up of the lump sum payment.

You incurred legal expenses in relation to the legal proceedings against the insurer.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5. 
Income Tax Assessment Act 1997 section 6-10 
Income Tax Assessment Act 1997 subsection 6-15(1)
Income Tax Assessment Act 1997 section 8-1 

Reasons for decision

Lump sum payment
Section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) provides that the assessable income of a taxpayer includes income according to ordinary concepts (ordinary income).

Ordinary income has generally been held to include three categories, namely income from rendering personal services, income from property and income from carrying on a business. 

Other characteristics of income that have evolved from case law include receipts that:

· are earned

· are expected

· are relied upon, and

· have an element of periodicity, recurrence or regularity.

The compensation offered to you is not income from rendering personal services, income from property or income from carrying on a business. The payment is also a one off payment and as such it does not have an element of recurrence or regularity. Although the payment may be expected, and perhaps relied upon, this expectation arises from the settlement of a legal dispute in relation to benefits provided under the policy rather than from a relationship to personal services performed.

A compensation amount generally bears the character of that which it is designed to replace. If the compensation is paid for the loss of a capital asset or amount then it will be regarded as a capital receipt and not ordinary income. 

Taxation Determination TD 93/58 indicates that where a taxpayer receives an undissected lump sum which includes assessable and non-assessable components that cannot be identified or quantified, the whole of the lump sum is treated as a non-assessable amount.

You received a lump sum payment as final settlement of your claims, associated interest and costs under an income protection insurance policy.

As you are unable to dissect the lump sum payment into its various components, the whole amount is deemed to be of a capital nature. Therefore, the lump sum amount is not assessable under section 6-5 of the ITAA 1997 as ordinary income.

Capital gains tax (CGT) arising from the lump sum payment

Section 6-10 of the ITAA 1997 provides that amounts that are not ordinary income but are included in assessable income by another provision, are called statutory income.

Taxation Ruling TR 95/35 deals with the capital gains treatment of compensation receipts. The ruling provides that an insured person's right of indemnity under a policy of insurance falls within the definition of a right to seek compensation. The whole of the settlement amount is thus treated as capital proceeds from a CGT event happening to your right to seek compensation.

The disposal of an asset gives rise to a CGT event. However, paragraph 118-37(1)(b) of the ITAA 1997 disregards a capital gain made from a CGT event where the amount relates to compensation or damages received for any wrong, injury or illness you suffer personally.

Your claims against the insurer relate to your personal injury or illness and any capital gain or loss arising from the surrender of your rights under this policy will be disregarded. As such, this amount is not statutory income.

Subsection 6-15(1) of the ITAA 1997 provides that if an amount is not ordinary or statutory income it is not assessable income. Consequently no part of the amount received is included in your assessable income.

Legal expenses
Section 8-1 of the ITAA 1997 allows a deduction for a loss or outgoing to the extent to which it is incurred in gaining or producing assessable income, except where the loss or outgoing is of a capital, private or domestic nature or relates to the earning of exempt income.

In determining whether a deduction for expenses incurred in relation to your lump sum compensation payment is allowable under section 8-1 of the ITAA 1997, the nature of the expenses must be considered.

The nature or character of expenses follows the advantage that is sought to be gained by incurring the expenses (Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634; (1946) 8 ATD 190). If the advantage to be gained is of a capital nature, then the expenses incurred in gaining the advantage will also be of a capital nature.

Through your legal action you obtained an undissected lump sum compensation payment which has been deemed to be a capital payment. As the advantage obtained is capital in nature, the legal expenses incurred are also capital in nature.

No deduction is allowed for your legal expenses under section 8-1 of the ITAA 1997.